Market Risk DefinedRisks pertaining to interest-rate and equity relatedinstrumentsForeign exchangerisk andcommodities riskthrough the bankThe risk of adverse changes inmarket values over a liquidationperiodWhat Is Market Risk?
5Trading BookBanking BookRISK MEASUREMENTRISK MEASUREMENTINTERNALCONTROLSSOURCESOFMARKETRISKRISK MANAGEMENT- Board and SeniorManagement Oversight- Policies, Procedures andLimits- Risk Measurement,Monitoring andInformation Systems- Internal Controls andAuditMODELS USEDEarnings-at-Risk = Short-termEconomic-Value-at-Risk = Long-termMODELS USEDValue-at-Risk- Variance/Co-Variance- Historical Simulation- Monte-Carlo SimulationRISK FACTORS- INTEREST RATE> Repricing Risk> Yield-Curve Risk> Basis Risk> Options Risk- EXCHANGE RATE- COMMODITY- EQUITYThis Schematic Shows How Market Risk (I.e., Risk Factors) Influences a Financial Institution. Note Thatthe Trading and Banking Books are Each Modeled and Managed Separately. This is the UsualEnvironment in Banking Organizations.
7Defining ALMIn its broadest sense, ALM is the financial riskmanagement of any financial institution.Risk Dimensions of ALM» Policy Setting» Structuring the Bank‟s Repricing and Maturity Schedules» Capital Management» Liquidity Risk Management» Internal Profitability Measurements» Contingency Planning: Analyzing the Impact of External Shocks andhow the Bank will Respond to those Shocks
8The Goal of ALMALMRiskVolatility ofCash FlowsLoss of Market ValueOpportunityForecastsStrategyReturnMission =Ensure Safety & Soundness + Maximize Risk Adj. Return
9The ALM ProcessRiskRepriseSubjective ObjectiveChoices of Tasks ofRisk Management Risk ManagementDefine Risk Policy Measure Current Risk ExposureTarget Accounts Across Individual Accounts andRate Forecast Balance Sheet as a wholeProbability of Rate OutcomesSet Risk LimitsMeasure Risk / Retrun Trade-OffHedging, restructuring analysisChoose Determine Efficient PortfoliosMost Subjectively Desirable Identify Efficient Combinations of Assets &Mix of Assets & Liabilities LiabilitiesSource: Measuring and Managing Interest Rate Risk: A Guide to Asset/Liability Models Used in Banks and ThriftsMorgan Stanley Fixed Income Research, October 1984
12A Brief History of ALM1970‟s» Focus on Forecasting NII» Little IRR ManagementEarly 1980‟s» IRR management focus on gap, duration, and simple simulations.» Rise of inter-departmental ALCOmid 1980‟s» Formal ALM, IRR management becomes a “unit” of the bankLate 1980‟s – Early 1990‟s» ALM gradually incorporated into strategic planning» Focus expands to capital adequacy and prudent leverage» Plain vanilla and then complex derivativesmid – late 1990‟s» ALM increasingly important in reducing performance volatility» Stochastic valuation gains ground» Tools grow in sophistication: customer behaviour modelling2000‟s» ALM is integrated with credit risk management, resulting in Enterprise Risk Management (ERM)» ALM increasingly embraces economic value as the primary focus» Liquidity Risk Management increases in importance
14Risk Management Tools1. GAP Analysis2. Net Interest Income Simulation (NII)3. Standard Market Value Sensitivity Measures» Duration and Convexity» Option Adjusted Valuation4. Volatility Based Risk Measures» VAR» EAR
15GAP Analysis» Gap analysis is an asset/liability management tool used tomeasure interest rate risk, make funding decisions, and allocatecapital along the yield curve.» Gap is simply the post-hedge difference between rate sensitiveassets and rate sensitive liabilities, bucketed into the sooner ofreprice, maturity, or expected call date.» When periodic gap is zero, net interest income is hedged againstchanges in interest rates. However, when there is a positive gap,earnings decline as interest rates decrease and rise as interestrates increase.» Gap is particularly useful for balance sheets that have littleoptionality.
17Gap Strengths»Easy and Intuitive to Understand»Development Costs are Small»Can Easily Set Risk-Limit Policies
18Gap Weaknesses» Sizeable mismatches can be hidden in buckets as short as onemonth.» Fixation on plugging Gaps to zero restricts ALM choices becausemany different non-zero Gap combinations immunize NII as well.» Cannot measure risk associated with options sensitive to interest raterisk such as prepayment options or deposit intangibles.» Gap does not provide a single index number quantifying the riskexposure of a target account.» Assumes interest rates change by the same amount for all assets andliabilities.» Cash flows of interest are ignored.» Administered non-market accounts such as prime or money markets?» Cannot manage more than one target account simultaneously.
20NII Simulation: The Brute Force Approach» A computer simulation model starts with the current balance sheet,including detailed maturity or repricing schedules and the associatedrates and yields of those balances, and forecasts the incomestatements, balance sheets, and cash flow schedules for a series offuture time periods, typically 12 to 36 months.» This is accomplished by literally simulating the repricings, maturities,rollovers, and new business originations for all balance sheetactivities of the bank!» To generate a plausible set of financial statements, assumptions mustbe made about a number of important issues, including targetbalances, maturity schedules for new business, yield curve behavior,non-yield curve rate assumptions, and pricing assumptions for newbusiness.
-20.00%-15.00%-10.00%-5.00%0.00%5.00%10.00%-300 -200 -100 +100 +200 +300Basis Points Rate Change (Parallel Shock)ChangeinNIIDec-00Jun-01Dec-01LimitsLimit Excess; Approved by ALCONII SensitivityNet Interest Income at Risk
23NII Simulation Strengths» Net interest Income simulation models seek to produce their results ina dynamic or forward-looking manner whereas market value and gapmodels produce their results statically.» Since simulation models are both forward looking and are interactive,they require greater emphasis on assumptions and managerialbehavior.» Therefore, simulations are unique in that they help managersanticipate future events, perform assumption sensitivity analysis, andprovide a means by which managers may test the effect of differentexternal shocks and strategies on income.
24NII Simulation Weaknesses» The software, hardware, and personnel requirements necessary torun an ALM model are costly.» Simulations depend on assumptions and data analyses that placestrenuous demands on the operator. Therefore, the simulation resultsare only as good as the analyst operating the model.» Simulation models bog managers down in oceans of detail.» Since simulation solves problems by trial and error, a thoroughexamination of current risks can be clumsy, time consuming, andlabor intensive.» ALM models can be black boxes. The internal structure of modelsmay not reflect the bank or thrift being modeled. In addition,econometric models and relationships may become invalid with time.
25Standard Market Value Sensitivity MeasuresMarket Value of Portfolio Equity (MVPE)» The market value of assets minus the market value liabilities.Duration: Generic Description of the sensitivity of a bond‟s price to achange in yield.» Macaulay Duration: The weighted average of the time periods over whichcash flows accrue to bondholders (using the percentage of the cash flows asweights) which occur at each payment time as the weighting scheme.» Modified Duration: Duration measure in which it is assumed that yieldchanges do not effect the expected cash flows.» Effective Duration: Sensitivity measure in which recognition is given to thefact that yield changes may change the expected cash flows (correlatedrisks).Convexity: The rate at which duration changes due to changes in interestrates.
26Convexity» Duration not constantover time» Convexity adjusts forinterest rate sensitivity -„curvature‟ of price/yieldrelationship» Relevant for largermoves.PriceDuration Actual Pricep*Tangent Line at y*y* Yield
27Optionality: Behaviour ModellingWhere Contractual Terms May Be Varied By Custom or Implication» Prepayment Due To Unscheduled, Part Or Full, Principle Repayments» The Variability and Lack of Sensitivity of Non Maturity Liabilities inTerms of:– Maturity– Changes in Balance of Account– Coupon or Interest Rate Repricing, or Rate Repricing Lag To MarketRates, Or The Rate Off-set Due To High Account Servicing Cost» Call Options, Put Options» Caps, Floors» Changing Credit Card Balances
28Option Adjusted ValuationHow Much Additional Risk am I really undertaking becauseof embedded optionality and how does it cost?» The option adjusted value (OAV) is the probability weighted market value ofall of the simulated income streams.
29What is Option Adjusted Valuation?» OAV is “beyond the option” in the sense that it is theexpected value across a large number of possibleoutcomes rather than just one path.» This market value is option adjusted because itincorporates market volatility and therefore, the changingmarket value of embedded options.» Static valuation is the outcome of a single scenario wheremany are possible!!
30Term Structure ModelingWhat is likely to happen to interest rates?» Stochastic generation of interest rates allows the user to effectively forecastthe future shape and behavior of the term structure of interest rates.-10%0%10%20%30%40%50%60%70%-2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5%Refi CPRRefi SpreadActual refinancing vs. S-like curve: 5/1 ARMsObservationsModel
32Effective DurationEffective Duration Recognizes that Changes in Yield will Change theCash Flows of Instruments with Embedded OptionsPriceDuration Actual PricePositive ConvexityNegative ConvexityYieldΔi ΔiV0 = initial priceV- = price if yield changes by -yV+ = price if yield changes by +yΔi = change in yieldDe =V- - V+2(V0)(Δi)
33Effective ConvexityEffective Convexity Recognizes that Changes in Yield will Change theCash Flows of Instruments with Embedded OptionsV0 = initial priceV- = price if yield changes by -yV+ = price if yield changes by +yΔi = change in yieldCe =V- - 2 * V0 + V+V0 * (Δi)2* 100
EVEExposures-60.00%-50.00%-40.00%-30.00%-20.00%-10.00%0.00%10.00%-300 -200 -100 +100 +200 +300Parallel Change in Rates%ChangeinEVEDec-00Jun-01Dec-01Limits
35Duration Strengths / WeaknessesStrengths» Shows magnitude and timingof cash flows.» Provides a single exposurenumber to manage against» Identifies which transactionsdrive exposures.» Easily accommodatesunusual security types andcorrelated interest rate risks.» Quantifies more than onetarget account at a timeWeaknesses» Assumes all interest rateschange in equal amounts» Only effective for small ratechanges (convexity).» Does not capture futurebusinessvolumes, managerialdecisions...etc.
VaR is maximum amount of money that may be lost on a portfolio over a given period oftime, with a level of confidenceVaRWhat is Value at Risk (VaR)?Methods:Historical simulationVariance-CovarianceapproachMonte-CarlosimulationProfitLossConfidenceLevel 99%
VaRStrengths and Weaknesses» Provides “common” denominatorupon which to manage risk» Attaches probability to magnitude ofloss» Allows for decomposition of risks» Susceptible to assumptions» Provides “likely” picture, but notextreme event results» Computational and resourcerequirements can be highStrengths Weaknesses
40What is EAR?Earnings at risk (EAR) is the maximum decline in earnings thatcan occur over a given period of time, with a level of confidence.
41Target Account Score Card1 is best, 3 is leastMaturityGap SimulationDurationGap1. Risk Measurement Accuracy 3 2 12. Risk in Several Target Accounts 3/2 3/2 13. Flexible Asset/Liability Choices 3 2 14. Comprehensive Treatment of Securities 3 2 15. Correlated Risks 3 2 16. Ability to Hedge Incrementally 3 2 17. Risk of to be Booked Positions 3/2 1 3/28. Risk Measurement of Individual Accounts 3/2 3/2 19. Flexible Display of Results 3 1 210. Reveal Assumptions Made X X X11. Distinction Between Book and Market Values X X XScore Card on ALM ToolsSource: Measuring and Managing Interest Rate Risk: A Guide to Asset/Liability Models Used in Banks and ThriftsMorgan Stanley Fixed Income Research, October 1984
42Ranking ALM Tools as the Basis forDecision MakingTarget Accounts: Proxies for measuring and controllingthe tradeoff between risk and return» Market Value of Portfolio Equity» Net Interest IncomeMinimizing risk in one category causesincreased risk in one or the other category!
Variety of Metrics Used to Quantify Risk By Exposure Type13%38%13%13%13%88%100%63%88%88%88%0% 20% 40% 60% 80% 100%Management ActionTriggersStop Loss LimitsVaRNet Interest IncomeSimulationConvexityDurationYes Non = 8
How Banks Quantify IRR – Advanced Analytics» 94% of a total population of 16 banks calculate and report NII exposure usingdeterministic rather than stochastic models. Therefore, minority of industry participantsuse stochastic income modeling despite their availability through common ALM systems.– Most management teams do not perceive a favorable cost/benefit to stochastic income modeling– Limited regulatory attention– Many industry participants reported longer duration assets with embedded optionality – thereby limiting theusefulness of stochastic modeling» 3 of 16 institutions calculate NII exposure using stochastic methods for internalcomparative purposes only (results not formally reported).– Option adjusted EaR– Multi-factor EAR– EaR hedge Analysis» 14 of 15 who do not use stochastic interest rate modeling perform non-parallel interestrate shocks.» Many banks use deterministic NII modeling to satisfy regulatory requirements.» VaR limit and compliance appears to be more prevalent amongst “market value” focusedfirms and are not common with “earnings focused” ones.45
Current EnvironmentLessons Learned Current ChallengesNeed for effective firm-wide risk identification andanalysis. Review and update risk managementpolicies, practices and governance structures Improvement in prospective and contingencymeasures Establishing firm-wide risk tolerancesConsistent application of independent and rigorousvaluation practices across the firm. Price and Value are two distinct things “Risk” is more complicated than “Price” Pricing should emphasize a MTM discipline Place reasonable prices on products within HFIbanking books, not just AFS and trading positions Develop ALM/BSM “independent” sources of pricing Consider pricing in your stress-scenariosEffective management of funding liquidity, capital and thebalance sheet. FTP charge for liquidity Appropriate contingent liquidity risk management Treasury functions aligned with businessesInformative and responsive risk measurement andmanagement reporting and practices. Risk metrics based one adaptive assumptions Different perspectives on risk exposures Stress testing not severe enoughThe industry and regulatory response to the market dislocations that began in 2007 have signaled renewed interest in ALMacross numerous financial disciplines. The acknowledgment of industry weaknesses and an atmosphere of very strongregulatory reform has signaled the incentive for change.• Measure &Consolidate BSExposure• Establish CentralizedReporting• Leverage Risk Mgt andBS Efficiencies• Balance &CommunicateAccounting vs.Economic Risk• Transfer Pricing
How Risk Management is Changing» Governance: Greater emphasis on ERM principles - Movement away from “silo” basedrisk management and the linking risk to capital» Risk Assessment: Asset/Liability management needs to be more prospective in order toidentify risks sooner» Risk Quantification and Aggregation:– More disciplined valuation practices across the firm– Convergence of market and credit risk– Proliferation of the Enterprise Risk Management Platform– Stress Testing – more realistic fat tail events and more holistic practices» Risk Monitoring and Reporting:– More responsive risk management reporting practices– Wider range of risk metrics based on different underlying assumptions» Risk Control and Optimization:– Effective management of funding, liquidity, capital, and capital management» Transfer pricing» Better Liquidity risk management practices» More efficient capital management» Risk adjusted performance measurement48
Traditional ALM Is Not Enough Anymore» ALM is too often equated to IRR, and only IRR. It‟s far more thanmeasuring IRR (Earnings & EVE)» The full scope about ALM is about the totality of the financial riskmanagement of a bank. That means:- ALM = Governance + Risk Assessment + Risk Quantification + Monitoringand Reporting + Risk Control and Optimization or ERM- Financial risks need to be modeled using instrument-level cash flows- Requires the joint modeling of financial risk across the taxonomy of risks» Sound balance sheet management means always striving to maximizevalue creation and minimize value destruction» This requires a view across the taxonomy of risk types» This is an on-going process» Requires a good valuation discipline, not just an earnings focus49
Traditional ALM –Interest Rate risk andearnings/valuescenario analysisModeling the earningsimpact of:• Delinquency• Non-accrual• Default• RecoveryModeling the credit capital of:• Current position inherent risk• Pro-forma credit capital• ALLL forecasting using theabove two itemsModeling the transitions ofcredit:Tying rating transitions tomarket spreads (CreditMetrics™approach)MTM (i.e., a “fair value”approach)Instrument level pricing ofcredit-default productsSensitivity analysis andreporting around currentand forecasted creditspreadsCDO and CMBS pricingmodulesLinking prepayment models andcredit (i.e., hazard-rate) models attransaction levelCredit Risk and ALMPhase 1Phase 2Phase 3Phase 1Phase 2Phase 3
Conclusion51“Banks that wish to remain competitive must keep up with the latestdevelopments in risk measurement and management…One of the mostimportant sound practices for a banking organization is the tying of riskexposure to capital…by more clearly defining risk exposures andidentifying the causes and controls for their losses, bank managementcan more effectively integrate decisions about risk-taking into theirstrategic and tactical decision-making.”- Governor Bies, U.S. Federal Reserve, March 29, 2006